Don’t expect unreal….

Don’t expect unreal….

After the market crash, where we had witnessed a big fall in days, weeks or months, it usually leads us to the assertion that stock is cheap and we can consider to buy it. Surely a stock whose price had fallen 20 per cent, 30 per cent or even 50 per cent lower from where it was trading few days, weeks or months ago is now cheap? The answer is maybe.

Stock prices over medium to long term reflect the fundamentals of the business. However, the short term price fluctuation reflects only the sentiments of the investor. Ben Graham, widely regarded as father of value investing, once said that “in the short run, the market is a voting machine but in the long run, it is weighing machine.” We already had witnessed that stock price are unduly punished despite the fundamentals look sound, there are instances where severe price declines are in fact warranted and reflect deterioration in the business.

To determine whether a beaten down stock is likely to be a good investment requires investors to know its estimate intrinsic value of the stock. That means – what stock is worth on its fundamentals and growth prospects. It is thus interesting to read or listen when stock is declared cheap on the basis of its decline, and nobody talking about what it is worth in the media or by many analyst and brokers. It is therefore very important to understand here that stock price is only cheap when materially its prices had fallen down to its estimate intrinsic value.

There might be more subtle reason, one that draws on behavioural psychology, which may help explain why so often investors hold the belief that a price rebound will be likely after a sharp fall. Daniel Kahneman and Amos Tversky, well known psychologist of today’s world had done research and written theories about anchoring, a psychological heuristic whereby decision making is subconsciously influenced by an unrelated reference point.

Let me give you a very recent example from the market. Many market participant had become accustomed to oil trading at around $100 per barrel; this served as a reference point to which future expectation of oil price were anchored. I had read in many annual reports where management had blamed about either oil trading below $100 or above $100 per barrel to their profitability. Even the government anchored to those levels and had talked about it in the budget in reference to their fiscal deficit. There was no shortage of claim in mid-2015 that oil won’t go below $60 per barrel.

In reality, the fact that oil traded above $100 per barrel in the past was no help in predicting a bottom of the oil price. What really mattered was an observation of global crude oil oversupply, caused in part by the rise of U.S. shale production and breakdown of cooperation between OPEC members. The oil price in fact halved to $30 per barrel to those expectations who are still waiting for oil price to go to its normal levels.

Investors are best served by avoiding stocks that look enticingly ‘cheap’ after large price declines, unless a thorough analysis suggest that stock is trading materially below its intrinsic value.

Aziz Dodhiya is the chief investment officer for the Valueoperations funds which operates in the Indian market as an FPI (Foreign Portfolio Investor). We do not offer any personal advice to buy or sell any stocks and the views that are shared by Aziz might not incline to your personal investment strategy and this is the reason we advise to take professional advice before going ahead with our views.